Wholesale Global Credit Income Update

How have recent events affected the management of the portfolio?

We are long-term investors seeking exposure to companies that we expect to provide robust returns on capital through the full credit cycle. Every corporate bond we purchase is reviewed by a specialist in-house team of credit research analysts and is assigned an internal credit rating. Analysts monitor evolving factors that affect companies on a daily basis. As risk changes, we act.

We are clearly in the midst of a repricing of risk globally, but we believe our overarching investment philosophy and our proactive response to changing market conditions over the past several months positions the Global Credit Income Fund relatively well compared with credit benchmarks.

How has the Fund been performing?

Returns in the calendar year to date are negative reflecting the blowout in credit spreads, but in a relative sense performance has been supported by some pre-emptive measures that were taken before the recent sell-off really took hold. Importantly, credit exposure had been reduced, leaving the portfolio with a more defensive tilt than usual. These moves proved timely as spreads have continued to widen.

Credit markets entered this sell-off having performed reasonably well in recent years. Valuations have been supported by accommodative monetary policy for a very long period of time and default rates have been tracking below long-term averages. This led to general comfort in credit risk, particularly when combined with investors’ chase for yield as prospective income returns from cash and government bonds have come down.

The extent of the coronavirus shock has resulted in intraday price moves in credit markets as large as we saw during the GFC. This reflects investors’ fear of the unknown. That said, credit spread levels are close to levels seen in early 2016 and not too far above levels at the end of 2018. At this stage credit markets are not pricing in a catastrophic event, rather a repricing of risk to levels only just above long-term averages.

Importantly, looking ahead we believe the Fund is reasonably well placed to withstand further market volatility and, potentially, an extended period of subdued economic activity.

What steps have been taken to minimise the performance impact of spread widening?

Specifically, portfolio positioning had become increasingly defensive during 2019 as valuations pulled away from fundamentals. Earlier this year, we further added protection through synthetic hedges (e.g. credit default swap indices) and increased the cash position of the portfolio to help cushion the impact of further spread widening and rising hedging costs. Further, these moves provide additional ‘dry powder’ to deploy and exploit opportunities that this market environment seems likely to present.

Further, as risks have increased around Covid-19 and the potential economic fallout of the disease, companies perceived to be most exposed have been sold. These divestments included Booking, Accor and EasyJet. In fact we consider these companies to be well managed and all three have improved their credit profile over recent years. Nonetheless, travel bans and disruptions have the potential to affect airlines and other companies exposed to corporate and leisure travel, in turn leaving creditors in these companies vulnerable to capital impairment.

It is hard to forecast how significant defaults might be in the period ahead. While default risks have increased – particularly among energy, leisure, and consumer cyclical names – it is important to remember that most companies should be able to withstand a period of slower growth. Most should be able to fulfil their debt repayment obligations as normal and in full.

What is the Fund’s current spread duration?

Over the past several years there have been increasing concerns around escalating structural risks in the investment grade credit market, particularly in terms of spread/credit duration and ratings (we wrote about this in mid-2018, please see here). Historically, the Fund’s spread duration has averaged around four years. In the past year, as part of decreasing overall portfolio risk as spreads have tightened, we have moved down the credit curve; credit duration in the portfolio is currently below three years.

What is the Fund’s current credit rating profile?

The composition of the portfolio by credit rating is broadly in line with that of the overall investment grade credit market. That said, investment is focused in entities that do not require a strong economic environment to deleverage. The Fund is also exposed to entities that have the competence and ability to maintain ratings of at least BBB throughout economic cycles. On an overall basis, we cannot recall a time where the portfolio has been more conservatively invested than it is now.

Could we be in for a ‘GFC’ type event?

Encouragingly, we estimate bank capital buffers and liquidity are in a significantly better position than a decade ago leading into the GFC and the European sovereign debt crisis. Lessons have been learnt. Using Central Bank stress tests based on these crises, all banks currently held in the CFS Wholesale Global Credit Income Fund pass comfortably. Nonetheless, we understand the situation is different this time around; consequently, we will continue to monitor stress areas, particularly in the SME (small and medium-sized enterprise) and trade finance spaces. Note, the Fund does not currently hold any exposure to offshore bank equity capital instruments. Overall, the Fund currently has a lower exposure to banks compared to the broader investment grade market.

Are credit markets still functioning normally?

Market liquidity has been largely as expected in a stressed market environment; less than ideal. The structure of the global credit market has changed significantly since the GFC. The current market structure has not yet been tested in this type of environment. Peer-to-peer trading is on the rise, but is not a panacea. At the same time, the sell-side’s broking ability remains an area of concern – broker /dealer balance sheets are in the process of shutting down, even from very low levels relative to what was seen prior to the GFC. Trading volumes have remained reasonably robust so far, but bid/offer spreads are significantly wider – e.g. ~40bps indicatively, from ~10bps prior to the virus-related sell-off. This makes sense considering the wide intra-day price ranges we have seen, but to execute liquidity (i.e. sell) could easily see a bondholder pay 20-100bps in the investment grade sector.

New issuance of corporate bonds has slowed. Companies only seem willing to issue during pockets of market strength. We’ve therefore seen a slowdown in the past few sessions, although encouragingly issues that have been offered have been met with good demand. Ultimately, with record low government bond yields and credit spreads that remain close to long-term averages, the overall cost of debt remains quite appealing for companies.

How has the oil price slump affected the portfolio?

Given the rapid fall in oil prices, we have been particularly focused on the Fund’s overall exposure to the energy complex. As at 11 March 2020, the Fund’s exposure to the Energy sector sat at 7.4%, with less than 1.0% in Oilfield Services (where holdings had an average credit rating of A) and less than 2.5% in BB and B rated entities. Note the broad investment grade market currently has a ~6.8% Energy weighting, while the high yield market has a ~11.5% Energy weighting. We are comfortable with the Fund’s current exposure to this part of the market, which includes blue-chip national champions in the sector such as Woodside Petroleum, BP, and Chevron.

Does the Fund have any exposure to Italian energy names, or banks?

In total, the Fund’s exposure to Italian-domiciled energy issuers is under 1% and limited to Enel (natural gas), and Eni (oil and gas), both of which have strong credit profiles. The Fund currently has no exposure at all to Italian banks, or to any other issuers in Italy.

How long might the volatility persist?

Nobody can say for sure, but in due course we may see opportunities in ‘fallen angels’; out-of-favour but robust cyclicals, for example, and highly-rated corporates that we perceive to have been oversold.

It is important to bear in mind that many companies in which the Fund invests should be able to withstand recessionary periods. Valuations of these entities are nonetheless being impacted by the broader market stress. Over time, this should present opportunities to increase exposure to good quality companies at appealing prices.

Overall, valuations currently reflect reasonable value, although forward-looking economic risks are significant and are evolving rapidly. Consequently we are remaining patient and cautious at this point in time. We might consider adding risk to the portfolio if:

• There is a favourable resolution to the oil price war (depressed valuations may see us increase exposure to low cost producers prior to this);
  
• Fiscal stimulus measures look like being effective in averting a more serious and lasting economic slowdown; and/or
• There is a clear flattening out of coronavirus cases globally and, in turn, an end to nationwide shutdowns and travel restrictions (at this stage, it appears disruptions are likely to get worse before they get better).

For more information about how virus-related disruptions are affecting debt markets, please watch our recent video with Tony Togher, Head of Short Term Investments and Global Credit.

Senior Global Credit Portfolio Manager Craig Morabito also participated in a teleconference on Friday 13 March 2020 with Dushko Bajic, Head of Australian Equities Growth and Peter Meany, Head of Global Infrastructure Securities to discuss the latest developments. You can listen to a recording of the call here.